A number of people who are building up a buy-to-let portfolio in their own name are asking whether they should incorporate the business in the light of the proposed restriction on relief for interest paid.
This is a surprisingly difficult question to answer. That is because there is no best approach. It depends on your individual circumstances and what you are seeking to achieve.
There can be tax advantages to running a letting business through a limited company as the company pays tax at 20% on income and capital gains. In comparison an individual pays income tax at 20%, 40% or 45% and capital gains tax on gains of 18% or 28% depending on their individual circumstances.
It is accordingly attractive to use a company if the money is left in the company. If you are creating the portfolio as your pension fund, you may be content to leave both the rental income and capital gains in the company until you reach retirement age.
If you need the rental income to live on or to supplement your earnings, there is extra tax to take the money out of the company. The most tax effective way to do this is to take the money out as a dividend. But even a dividend is taxable as income, albeit at special rates that are lower than the normal tax rates.
Next, let’s look at the effect of borrowing. Suppose the £1,000 of income is £1,700 rent less £700 interest.
The figures using a company are unchanged because full corporation tax relief is given for the interest. However the figures if you do not use a company become:
Clearly each individual’s proportion of interest to net rent before interest will be different as it will depend on a number of variable factors. The break-even point for a 40% taxpayer is £300, i.e. if £1,000 of net income is greater than £1,300 before deducting the interest, it is better to use a company. The corresponding figure for a 45% taxpayer is £219.20.
But you cannot stop there. What happens when a property is sold?
So, for a 40% taxpayer, the choice is between paying an extra 18% (a 55.55% increase) on the gain in order to reduce the tax on the annual income. For a 45% taxpayer, it is an extra 22.48% (an 80.29% increase).
Accordingly if the potential capital gain is of greater attraction than the annual income, using a company is unlikely to be attractive.
If you regard extra tax on the eventual capital gain as an attractive trade off against less tax on the annual rental income, there is one more potential problem, namely how do you get the property into the company?
Transferring the property to the company normally involves an immediate charge to both Stamp Duty Land Tax on the current value and capital gains tax on the gain to date. How will you fund this tax? In some cases the company may be able to increase the borrowings on the properties, but this will not always be possible.
There is a bit of good news.
If the company buys your property from you for £500,000, it will owe you £500,000. It can settle this by paying you its net rental income after corporation tax. That would mean that the overall tax rate on the first £625,000 of income (probably 7 or 8 years income) reduces to 20%.
In some cases your property business can be transferred to the company in exchange for shares without triggering the CGT (although not without the company having to pay the SDLT). The problem is that it is not clear which cases will qualify. The tax can be avoided if a “business” is transferred to the company, but simply holding property to generate rents is unlikely to be regarded as a business. If you engage staff to run your property portfolio or you work full-time on running it, the portfolio is likely to constitute a business. If you have two or three properties and use an estate agent to manage them, it is unlikely to do so. The problem is that most portfolios fall somewhere between these two extremes.
Unfortunately assuming you have a business and failing to convince HMRC gives the worst of all worlds. You would have to pay the CGT but by transferring in exchange for shares, you will have lost the ability to withdraw funds from the company at the 20% tax rate.
If you would like to discuss these issues further, or any other tax planning opportunities, please get in touch.